Price Channel
The Price Channel or
Donchian's Four Week Rule is
a simple and effective trend
following, channel breakout
system.
Overview
Channel breakout systems
were shown by research
to be one of the top
trading systems to
generate significant
profits
-
Developed as the 4
Week Rule by Richard
Donchian, originally
for commodity
trading
-
Can be used on
daily, weekly and
monthly charts
Louis Lukac's research from
1975 to 1986 compared 23
trading systems. Moving
averages and channel
breaklouts came out as the
top performers and Lukac
suggested a channel breakout
as the best starting point
for technical trading. (Lukac,
Louis; The Financial Review,
November 1990).
Interpretation
The Price Channel is a
simple breakout system. As
with all trend following
systems, the Price Channel
works well in up trends or
down trends, but doesn't
work well in a sideways
channel. The signals derived
from the Price Channel are
based on the following basic
rules:
-
When the price is at
its highest in a
four week period,
buy long and cover
short positions
-
When the price falls
below the lows of a
four week period,
sell short and
liquidate long
positions
As a trend following system
the Price Channel indicator
is not meant to catch tops
or bottoms. Trend traders
may want to extend the
period to eight weeks to
wait for significant trend
signals. Similarly, some
traders shorten the time
period to a more sensitive 1
or 2 weeks for liquidation
purposes.
Signals
The following signals are
offered by the Price Channel
indicator:
-
A buy signal
is generated when
prices penetrate and
close above the
upper channel.
-
A sell signal
is generated when
prices penetrate and
close below the
lower channel.
These signals should, of
course, be combined with the
use of other indicators to
provide confirmation. For
example, a relatively
simple, yet effective,
approach to exiting a trade
based on a price channel
would be to watch for a
break in the long-term
trend.
Some Ideas for Applying
Shorter Time Periods:
-
Can be used to
identify trend
reversals
-
When prices are
trending sharply
higher, shorten the
time span for needed
sensitivity
-
Use a four week rule
for entry and one or
two weeks to signal
exit points.
-
A two week price
breakout in the same
direction as a
moving average
crossover signal,
makes an exceptional
filter on which to
base a market
decision
-
A stop-loss could
trail with a one
week lag